Liquidation in DeFi happens when the value of your collateral falls enough relative to your borrowed amount that your health factor drops below 1. At that point, external liquidators can repay part of your debt and claim your collateral at a discount, typically 5 to 15%. The protocol stays solvent by passing the liquidation incentive to whoever executes the call, rather than absorbing the loss itself.
How DeFi liquidation works
When you borrow in a lending protocol, the protocol assigns you a health factor: the ratio of your collateral value (adjusted for each asset’s collateral factor) to your total borrowed value. Aave uses a health factor where anything above 1 is safe and below 1 triggers liquidation. Compound uses a similar borrow limit model. MakerDAO uses a collateralization ratio: for ETH vaults, the minimum is 150%, meaning you must hold at least $150 of collateral for every $100 of DAI borrowed.
Liquidation bots monitor all active loan positions constantly and trigger the liquidation call the moment a position becomes eligible. The liquidation discount compensates the bot for gas costs and creates the incentive to act promptly. If no bot liquidates quickly and the position becomes severely undercollateralized, the protocol absorbs a bad debt, funded by its insurance reserves or token holders.
What this means for traders
The most common mistake is underestimating how quickly health factors deteriorate in fast-moving markets. A position at 1.5 health factor during normal conditions can reach 1.0 in minutes if the collateral asset drops 10% and the borrowed asset is stable. Monitoring through DeBank and Aave’s native interface is not optional for anyone carrying leveraged DeFi positions. Set price alerts at the collateral price that puts your health factor at 1.2, giving yourself a 20% buffer before liquidation.
The cleaner risk management approach is keeping health factors above 2.0 unless you are actively monitoring. See: DeFi lending explained and price oracles, which are the mechanism that determines your collateral value in real time.
A concrete example
You deposit 10 ETH at $3,000 ($30,000 collateral) in Aave v3 and borrow $18,000 USDC. Aave’s liquidation threshold for ETH is 82.5%. Your health factor: ($30,000 x 0.825) / $18,000 = 1.375. If ETH drops to $2,200, your collateral falls to $22,000. Health factor: ($22,000 x 0.825) / $18,000 = 1.008. One more 0.8% drop in ETH triggers liquidation. The liquidator repays $9,000 of your USDC debt and receives $9,450 of your ETH at a 5% discount, leaving you with the remaining collateral minus the shortfall.
Frequently asked questions
Can you be partially liquidated?
Yes, most protocols implement partial liquidation: only enough collateral is sold to bring your health factor back above 1. Aave’s close factor is typically 50%, meaning at most half of your position is liquidated in a single event. You may need multiple liquidation events to close a severely undercollateralized position, each time losing the liquidation penalty.
What is a liquidation cascade?
When many positions share the same collateral asset, a price drop triggers simultaneous liquidations. Each liquidation sells the asset, pushing the price further down, which triggers more liquidations. March 2020 and November 2022 both saw cascading liquidations amplify a market move. Large positions in major lending protocols now have real market impact during stress events.
How can you avoid liquidation without closing your position?
Add more collateral to increase your health factor, or repay part of the debt to reduce the borrowed amount. Some protocols (Aave v3) allow e-Mode for correlated asset pairs, which gives you a higher loan-to-value ratio and reduces liquidation sensitivity when borrowing and collateral move together, such as borrowing USDC against stETH.
